STATES OF JERSEY

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Anti-inflation Strategy

 

Presented to the States on 11th February 2008
by the Minister for Treasury and Resources

 

 

 

STATES GREFFE

A NEW ANTI-INFLATION STRATEGY FOR JERSEY

 

This new anti-inflation strategy is presented to the States by the Ministers for Treasury and Resources and Economic Development. It is designed to update the current States anti-inflation strategy which is now 7 years old. The approach taken is to examine the nature, causes and costs of inflation in Jersey and develop a strategy that will address the fundamental issues for a small island economy like ours.

 

The conclusion is very much that there are no quick wins or easy options in controlling inflation and that many of the key ingredients for an anti-inflation strategy are already in place. The new strategy is about building on current policies and strengthening them rather than introducing new initiatives. There is a window of opportunity for the Island created by favourable global inflation trends and the success the Island has had in reducing inflation in recent years. This strategy aims to seize that opportunity and attempt to lock Jersey into low inflation.

 

The new Strategy puts forward 9 areas for action. Key points include to –

 

o                    Retain the current inflation target of 2.5% for RPIX.

 

o                    Set policy relative to the economic cycle and undertake the appropriate research to do so.

 

o                    Set fiscal (tax and spending) policy following guidance from the Fiscal Policy Panel and develop the new Fiscal Framework further on their advice.

 

o                    Review the effectiveness and resources of the Jersey Competition Regulatory Authority (JCRA) and the Jersey Consumer Council (JCC).

 

o                    Examine whether the Regulation of Undertakings and Development Law (RUDL) can be applied in a manner that better facilitates productivity improvements and competition.

 

o                    Charge Economic Development with the long-term objective (beyond the current Economic Growth Plan) of delivering productivity improvements across the economy.

 

o                    Consider how the new Island Plan can facilitate productivity improvements and better take account of market signals.

 

o                    Review the impact of States housing policies on housing demand in the Island.

 

o                    Raise awareness and understanding of inflation in the Island as everybody – employees, employers and the States – has a role to play in controlling it.

 

Summary

 

The attached paper looks at what inflation is, the main causes of inflationary pressure, the costs of inflation and the experience in the global economy, UK and Jersey. Drawing from this analysis this summary sets out what the key ingredients of an anti-inflation strategy should be for Jersey. It represents a framework within which policy should be developed.

 

What is inflation?

 

Inflation is a general rise in prices across the economy. The inflation rate is a measure of the average change in prices across the economy and is normally measured by the percentage change in the retail (or consumer) price index.

 

A rise in the price of any particular good or service can influence the rate of inflation but this not the same as a rise in the inflationary pressure in the economy.

 

The real inflationary danger in an economy is a build-up of inflationary pressure which occurs when the overall level of demand for goods and services exceeds the ability of the economy to supply them.

 

There are 2 primary causes of inflation: firstly, demand-pull inflation where the level of demand rises above the level of supply; secondly, cost-push inflation where the supply base contracts below the level of demand due to a rise in costs such as wages and/or input prices.

 

The costs of inflation

 

Experience across the Globe has shown that high inflation can undermine economic growth and leads to volatile economic cycles of boom and bust. In particular as far as Jersey is concerned, high inflation will –

 

·                     undermine economic efficiency – and therefore economic growth;

 

·                     reduce the competitiveness of export businesses;

 

·                     make Jersey a less attractive place to do business and live.

 

Global inflation trends

 

There has been success across the globe in the last 15–20 years in reducing inflation as a result of better policy-making, globalisation and stable economic conditions (see Chart 4). This success was reflected in trends in the UK (and France) and more recently in Jersey.

 

The global inflation outlook and the recent trends in Jersey (shown in the chart below) provide a window of opportunity to ensure that policy in Jersey locks into this low inflation environment and even if some of the favourable trends go into reverse.

 

Chart 1: Sustained fall in Jersey inflation

% change in RPIX

Source: States of Jersey Statistics Unit/National Statistics

 

 

Complacency because there has been success in Jersey in reducing inflation in recent years would be a grave mistake. Experience shows that inflation trends can quickly change and inflation can take hold, bringing with it all the problems described above.

 

The aim of this new-anti-inflation strategy is to lock in the improvements that we have seen in inflation in Jersey and lay solid foundations for the Island’s future economic success.

 

The key components

 

1.         An inflation target

 

The previous anti-inflation strategy agreed by the States in 2000 adopted an inflation target of 2.5% for RPIX (retail prices index excluding mortgage interest payments).

 

There has been considerable success across the world economy with inflation targeting, although this has been as a target for monetary policy. Although Jersey does not have its own monetary policy (because it is in a monetary union with the UK) an inflation target is still an important part of anti-inflation policy. This is because it acts as an anchor to which people can refer, and provided that it is backed by credible policies will also help to keep expectations about inflation in check. Without an explicit inflation target, people and businesses are less aware of what policy is trying to achieve and this may even mean that anti-inflation policy is less effective. The intention is not to meet the target at all times (even economies with control over their own interest rates do not attempt to do this) but the aim to keep inflation close to target over the medium-term.

 

The previous target of 2.5% is consistent with an approach that focuses on price stability, the ultimate aim of inflation policy. The fact that it has been the target for the last 7 years also means that policy will benefit from consistency from continuing with the same target.

 

RPIX is also the right index of retail prices to target in general because it excludes the impact of interest rates which can create distortions in the measure of inflation. For example, in the short-term higher interest rates push up RPI and this could be interpreted as higher inflation, but in reality the higher rates will act to keep inflation under control and help meet the inflation target.

 

The UK moved from targeting RPIX to a new index, the Harmonised Index of Consumer Prices (CPI) in December 2003. On average, RPIX in the UK has exceeded CPI by 0.7% between 1989 and 2007. This suggests that there could be some potential benefits from moving to CPI in Jersey. However, with a host of new inflation measures just introduced (RPIY, RPI low income and RPI pensioners) further consideration should be given to the potential benefits, the differences between the 2 measures, costs in terms of resources required to produce another index and risks to transparency from changing index and target.

 

Action 1: Retain the current States inflation target of 2.5% for RPIX over the medium-term.

 

Action 2: States Economic Adviser and Head of Statistics to report to the Council of Ministers in first half of 2008 as to the advantages and disadvantages of producing a new CPI (including resource implications) and using it as the target measure of inflation.

 

2.         Managing balance between overall demand and supply

 

(a)        Understanding the economic cycle

 

The analysis in this paper (section 3.1) shows that the critical issue in managing inflation in an economy is to get the balance right between the overall level of supply and demand in the economy. Policy needs to be set according to whether the economy is operating with spare capacity (supply is greater than demand) or excess demand (demand exceeds supply). Where the economy is in the economic cycle and the degree of spare capacity are primary issues in determining anti-inflation policy.

 

To date, no detailed research has been done on the Jersey economic cycle and the degree of spare capacity in the economy at different stages in the cycle. This is a prerequisite for anti-inflation policy.

 

Action 3: Economic Adviser to undertake in 2008 research on the economic cycle and degree of spare capacity in the Jersey economy and ensure it can be monitored on an ongoing basis.

 

(b)        Managing demand in the economy

 

Fiscal Policy

 

P.133/2006, which was agreed by the States in October 2006, set out a new Fiscal Framework, which had as one of its key objectives meeting the States inflation target. The analysis in this report shows that government expenditure is a key contributor to aggregate demand and therefore inflationary pressure when there is little or no spare capacity in the economy. The new Fiscal Framework is designed to ensure these economic issues are given detailed consideration when setting tax and spending policy.

 

The new Fiscal Policy Panel (FPP) will feed independent high level economic advice from 3 top economists into the annual budget process ensuring that economic considerations are given full attention. The objectives are that the Framework will lead to a more transparent and credible process for making tax and spending decisions in the Island. It will also help ensure that fiscal policy is set to be more countercyclical and therefore maximise the economic potential of the Island, but also help meet the inflation target.

 

The Framework incorporates the Stabilisation Fund, with the Minister for Treasury and Resources responsible for its operation, but having regard to the advice of the new independent FPP. The role of the FPP is to publish an annual report in September each year for the Minister for Treasury and Resources that –

 

The new Fiscal Framework is therefore the key ingredient of the new anti-inflation strategy. In a small island economy with limited spare capacity, due to the tight land and labour constraints, getting fiscal policy right and ensuring that it does not add to inflationary pressure at critical times in the economic cycle should be the primary aim. With no control over interest rates it should be the first objective of any anti-inflation strategy.

 

Fiscal policy must be set with reference to the degree of spare capacity, the position in the economic cycle and the level of real interest rates in the economy. The work undertaken as Action 3 will help to provide the FPP with the information they need.

 

Structure of demand

 

In setting policy it is also important to recognise that Jersey is an economy where just over 50% of activity is financial services (with a high proportion of other activity directly related to this) and that export demand is the key driver of economic activity. The nature of the financial services industry is such that it can go through periods of very strong growth – recently it has been growing in real terms at 12% – and this can feed directly into the other components of overall demand (increasing the risk of inflationary pressure), namely –

o        consumption – through wages (including bonuses) and employment growth;

o        government expenditure – through increases in tax receipts;

o        investment – both directly and by other industries that are linked to it.

 

Without control over interest rates the States has few tools at its disposal to mange these upturns in demand. Clearly the primary aim has to be to ensure that the combination of tax and government expenditure does not add to excess demand in the economy at certain stages of the economic cycle. The new Fiscal Framework is set up to achieve just this, but it will be important that the States, businesses and individuals all work to ensure that these upturns do not feed through into higher costs and prices.

 

Interest rates

 

The analysis in section 3.2 of this report shows that, because interest rates in the Island have been set relative to economic conditions and inflation trends in the UK, at times they have not been helpful in controlling inflation in Jersey. This is because the economic cycles in the UK and Jersey are not closely aligned and that the extent of spare capacity in each economy is not closely aligned as a result.

 

The analysis shows that rather than just accepting that interest rates are out of the Island’s control, that the appropriate approach is to ensure that the balance of policy between interest rates and fiscal policy are set relative to the economic conditions in the Island. The new Fiscal Framework including the Fiscal Policy Panel is designed to help achieve this and the advice of the Panel will be a vital ingredient.

 

Action 4: Treasury and Resources Department, Economic Adviser and Fiscal Policy Panel to review the new Fiscal Framework by early 2009 following the publication of the FPP’s first report to see if it can be improved to better meet these objectives.

 

(c)        Supply side

 

Competition

 

Section 3.3 in this report shows that the UK’s experience in the 1990 and 2000s and recent experience in Jersey (see chart below) illustrate the important role competition can play in keeping inflation under control. Ensuring there is vigorous competition between firms helps keep inflation down and is critical to maximising productivity and economic growth. Competition encourages firms to improve efficiency and innovate, puts downward pressure on costs and improves the organisation of production. All these factors combine to help keep inflation under control and the end result is a better deal for consumers.

 

Chart 2: Favourable trends in UK not reflected in Jersey

% change in price index 1991–2007

Source: States of Jersey Statistics Unit/National Statistics

 

There has been a stream of economic research looking at the benefits of competition which shows that it is closely linked to dynamic and efficient markets. Research has shown that –

·         Competition can have a positive impact on efficiency and productivity

·         Market power tends to reduce the rate of innovation and productivity growth

·         Increased market concentration is associated with reduced efficiency

·         Entry and exit of firms in the market place can help productivity growth

·         New businesses tend to bring higher rates of productivity

·         Firms that face strong domestic competition perform better in export markets

 

The previous anti-inflation strategy aimed to ‘develop policies for introducing more competition in the Island’s product markets’. A big step has been taken since then with the introduction of the new Competition Law. However, the role of the Jersey Competition Regulatory Authority (JCRA) is critical in ensuring the Law is effective.

 

Experience elsewhere and recently in Jersey highlights how public pressure and consumer representation can also achieve results in terms of making markets work and keeping prices down.

 

Action 5: Minister for Economic Development to review in 2008 the effectiveness and resources of the JCRA and JCC in achieving the overall objective of increased competition.

 

Regulation of Undertakings and Development Law (RUDL)

 

Allowing markets to work efficiently is an important part of creating the conditions for competition to prevail. Somewhat uniquely, the Island has RUDL which can influence the effective operation of product and labour markets. RUDL can affect the level of competition in the Island through allowing (or preventing) firms to enter the market. Given the important role competition has in meeting the Island’s economic objectives of low inflation with economic growth, RUDL must be applied in a manner that gives full consideration to the implications of decisions on competition.

 

RUDL also impacts on the operation of the labour market in the Island. This is because businesses need an RUDL licence to employ people in the Island. The efficient operation of labour markets is an important aspect of keeping costs under control and preventing cost-price inflationary spiral. RUDL has a number of objectives including managing the pressure on the Island’s resources and maintaining competition. It is important that it also operates in such a manner as to allow the labour market to operate efficiently.

 

Action 6: Minister for Economic Development to bring forward proposals in 2008 on how RUDL can operate more effectively in helping the Island to meet its economic objectives and in particular facilitate productivity improvements, competition and a freely functioning labour market.

 

Availability of resources

 

As the analysis in the paper shows, inflationary pressure is the result of the interaction of the overall level of demand and supply in the economy. Policies that can help to increase the supply side of the economy can mean that for any given level of demand, inflationary pressure is less likely to build up.

 

One way to facilitate supply side improvements is by increasing the amount of resources available whether it is land, labour or capital. For small island economies like Jersey this is difficult to achieve to any great extent as the amount of resources at the Island’s disposable are restricted by –

 

o        its relatively small size;

o        population policy;

o        the need to protect countryside and coastal areas.

 

Opportunities like the Waterfront which through land reclamation bring new areas of land into economic activity are rare, but the benefits clear to see in terms of boosting the Island’s supply capacity. Where there are further opportunities such as ‘East of Albert’ there could be some scope for further supply side improvements.

 

The consultation and formation of the new Island Plan will also be important in determining what land is available for economic use over the next 15 years.

 

Section 3.5 shows how the period of sustained economic growth and low inflation in the UK in the 1990s and 2000s has been built on sustained inward migration, growth in the working age population and employment and in contrast to the trends seen in Jersey over the same period.

 

The consultation process around Imagine Jersey 2035: preparing for the future will consider the direction the Island wants to take going forward in terms of population policy and the availability of people of working age. Once the Island has decided what the direction should be, the primary focus in terms of supply side issues will be using the land and labour the Island has at its disposal to the maximum effect.

 

Work already underway on the new Island Plan, Imagine Jersey 2035 and further development of the Waterfront will be critical in determining the supply capacity of the Island in the future and hence its ability to manage inflation.

 

Using resources efficiently

 

Once the Island has determined what is acceptable in terms of inward migration and land use, the emphasis for delivering supply side improvements is on making better use of the resources at our disposal, i.e. productivity improvements. That is, producing more with the same resources.

 

Section 3.5 shows that the UK’s success in the 1990s and 2000s in keeping inflation under control has been built on sustained employment and productivity growth. The States Economic Growth Plan sets out how the Island can deliver productivity improvements. The focus is on all the key components of productivity growth, namely –

 

o        skills

o        investment/infrastructure

o        innovation

o        competition

o        enterprise and

o        macro-economic stability.

 

These key building blocks for productivity need to be at the centre of Economic Development Department policy beyond the life of the current Economic Growth Plan and into the long term if supply side improvements are to underpin future economic growth and keep inflation under control. Planning policy is recognised across the world as being a constraint on productivity – the new Island Plan must reduce this barrier to productivity growth but without jeopardising wider social, environmental and design objectives of the Plan.

 

Action 7: Sustained productivity growth to be the long-term objective of the Economic Development Department beyond the life of the current Economic Growth Plan.

 

Action 8: Minister for Economic Development in 2008 to advise Minister for Planning and Environment how the new Island Plan can facilitate productivity improvements and better take account of market signals.

 

(d)        Housing policy

 

Trends in the housing market are examined in section 3.6. They can have a significant impact on inflation in the Island as they feed directly into the RPI and can also influence demand and supply in the economy overall. Higher house prices can bolster demand in the economy through wealth effects, but can also impact on the supply side through wage demands and labour mobility.

 

The improvement in inflation in Jersey in recent years has been accompanied by lower house price inflation. While it should not be taken that the two are directly linked (both will be affected by the economic cycle for example) it will be important to maintain a balance between housing demand and supply going forward. The recent rise in house prices, the high level of house prices relative to earnings and concerns about affordability for first-time buyers all serve to emphasize the need to ensure that house price inflation does not accelerate and undermine the ability to keep inflation on target.

 

Work is already underway on the new Island Plan which will be critical in determining the supply of housing in the future.

 

Action 9: The Economic Adviser in 2008 to review the interaction of all States housing policy to determine its impact on housing demand and suggest areas for reform (if required) that will better enable housing demand to be more in line with supply in the future.

 

3.         Communicating policy

 

A key element of successful anti-inflation policy is effective communication. Policy must be credible, transparent and widely understood if it is to achieve its aims. Another key component of the new strategy is to raise awareness and understanding of what causes inflation in Jersey and what the consequences are for the Island of failing to keep inflation under control.

 

The more widely understood the implications of inflation are and the policies that are in place to control it, the increased possibility of success. Everybody has a role to play in terms of keeping inflation in check – employers, employees and the States. All parties need to understand what causes inflation and their role in keeping it under control.

 

If action is taken in all the areas outlined above and the work that is already underway properly addresses the issues raised, then Jersey will have the right polices in place to keep inflation on target in the future. If action is not taken, the Island could easily be exposed to a change in the inflationary winds that stems from outside the Island. As Kenneth Rogoff said when he was IMF Economic Counsellor in December 2003 if the favourable winds do change then –

 

“Those countries that have taken advantage of the present benign inflation environment to strengthen their institutions will be well placed to ride out the storm. Countries that have done no more than let the winds of globalization bring down their inflation rates may be seriously vulnerable to reverse.”

A NEW ANTI-INFLATION STRATEGY FOR JERSEY

 

1.         Understanding inflation

 

What is inflation?

 

Inflation, put simply, is a general rise in prices across the economy. The inflation rate is a measure of the average change in prices across the economy over a specified period (12 months in the case of the annual rate of inflation).

 

To get an understanding of what the current rate of inflation is, it is necessary to measure the change in prices across the economy. This is normally done by constructing an index of prices and measuring its percentage change over time. The most commonly used index is a Retail Prices Index (RPI) which is made up of the weighted prices of hundreds of goods and services in retail outlets such as supermarkets, petrol stations, travel agents and insurance companies.

 

A rise in the price of any particular good or service can influence the rate of inflation, if it is large and/or the good/service has a significant weight in the index. For example, suppose the price of petrol has a weight of 20% in the RPI (far larger than is the case) and it rises by 20% in a particular month. If all other prices remain unchanged this would lead to a 4% rise in the index and inflation in that month. However, if all prices in the index stay unchanged, in the same month of the subsequent year the impact falls out of the annual comparison.

 

This example is illustrated in the chart below –

 

Chart 3: The impact of a one-off price increase on the RPI index and inflation

 

RPI index where January Year 1 =100 and petrol prices make up 20% of RPI index and rise by 20% in June of Year 1, with other prices constant

Source: Economics Unit

 

A one-off increase in the price of goods such as the example outlined above can clearly impact on the inflation rate but is not considered to be a rise in the general level of inflationary pressure in the economy. The fact that the impact falls out of the annual comparison shows that the impact is only short-term, unless it generates any second-round effects (discussed in more detail below).

 

How inflationary pressure affects the rate of inflation

 

The real inflationary danger in an economy is not then from a one-off price increase, but from a situation where there is a build-up of inflationary pressure in the economy. Inflationary pressure occurs when the overall level of demand for goods and services exceeds the ability of the economy to supply them (putting upward pressure on prices).

 

This might occur if incomes (personal and/or government) rise across the economy due to a windfall to the government. For instance, if oil was discovered in Bailiwick waters, the States of Jersey might be able to reduce taxes and increase expenditure. However, if there is no extra capacity in the economy to meet the extra demand for goods and services (both from the government and consumers with additional spending power) then inflationary pressure will be created and the general rise in prices that comes with it.

 

Expectations can also have a crucial impact on the inflation rate and inflationary pressure. If businesses and employees expect inflation to rise over the coming months they are likely to factor this into the prices they charge and the wages they demand. If this results in even higher prices, then an upwards spiral effect can be created. Central bankers across the globe have been successful at reducing inflation because of their ability to reduce inflation expectations across the economy by adopting inflation targets.

 

In the example cited above looking at the impact of a one-off increase in the price of oil, there could be 2 important second-round effects that could mean the initial one-off rise in the price level has a lasting impact on inflation –

 

-                    Firstly, oil is an important input into many business activities and a sustained increase in the oil price could actually reduce the supply capacity of the economy. If demand is unaffected (or affected to a lesser degree) then the balance between supply and demand could be altered and inflationary pressure could increase as a result.

 

-                    Secondly, there could be second-round effects where businesses and/or people respond to the initial increase by increasing prices and/or wages and that cost-push inflationary pressure could result.

 

The costs of inflation

 

Having considered what inflation is and how it is measured, the obvious question is why is so much emphasis placed on controlling it? The best way to see how damaging inflation can be is to contrast it with a situation of price stability.

 

Price stability enables money to work as the means by which people and businesses transact and contract with one another. The main problem with inflation is that people and firms change their behaviour as they attempt to avoid the uncertainty associated with rising inflation. Price stability helps create an environment where economic growth may occur more easily. Inflation, on the other hand, results in the country’s economic resources being used less effectively and efficiently than they could be. Economic growth suffers as a result.

 

Another way in which inflation impacts on the economy is by clouding relative price signals. When inflation is high, for instance, it can be volatile. It therefore becomes less clear whether an increase or decrease in the price of goods or a service reflects a change in the relative demand or supply, or whether it is just part of a generalised movement in prices across the board. On the other hand, if prices are stable, people and companies are able to make their investment, saving and purchase decisions more accurately without distorting signals. There is also the possibility that inflation will have an inequitable impact – hitting those people that save for retirement harder than those that simply spend their money on goods.

 

Many years of experience across different economies have shown that one of the main consequences of high inflation has been greater instability in economic conditions. Periods when demand has been growing more rapidly than output and inflation has risen have been followed by periods when demand and output (and employment) have fallen sharply (the boom and bust cycle). These falls were probably greater than would have been the case had demand and output grown at a steadier and more balanced pace.

 

What does this mean for Jersey?

 

Putting this in a Jersey perspective, higher inflation would have damaging implications for the Island because it will –

 

·         undermine economic efficiency and make it harder for the Island to achieve sustainable economic growth;

 

·         reduce the competitiveness of the Island’s many export industries such as finance, tourism, agriculture and fulfilment;

 

·         make Jersey a less attractive place in which to do business and live.

Understanding aggregate demand and supply

 

If inflationary pressure in an economy is due to the overall level of (aggregate) demand exceeding the overall level of (aggregate) supply then it is important to understand fully what determines aggregate demand and supply in an economy.

 

What is aggregate demand?

 

Aggregate demand (AD) is the total demand for goods and services produced in the economy over a period of time.  It is made up of 4 parts –

 

·         Consumption (C) expenditure: demand by individuals

·         Business domestic investment (I) expenditure: demand by businesses

·         Government (G) expenditure: demand by government

·         Net exports (X-M): demand by the rest of the world for an economy’s output

 

Therefore the level of aggregate demand in an economy is given by: